Keep a Wary Eye on That Hedge Fund

September 01, 2005

Investors always seem to be the last to know when a hedge fund blows up. One month they get a statement saying their investments are intact, and the next the manager has flown the coop, no one picks up the fund's phone, and all the money is missing.

Even professional investors can get take n off guard -- as they did in the recent blowup of Bayou Management, the $400 million Connecticut hedge-fund firm now under investigation for allegedly defrauding investors. The good news is that with new government rules in place and big investors throwing more money at hedge funds, the industry may slowly be changing.

For example, regulators now require that all hedge funds operating in the U.S. that have more than $25 million in assets must register with the Securities & Exchange Commission. Complying with these rules may weed out some bad apples from the get-go. But as the industry evolves and matures, the best shops are standardizing their procedures and providing investors with more transparency about their operations.

ADJUSTMENT PERIOD. Research shop Greenwich Associates calls it "professionalizing" -- the steps funds take to meet the disclosure requirements of big investors, who are expected to increase their current $11 billion in hedge-fund assets to $250 billion over the next five years.

"Institutional investors require...more operational supervision, and the hedge-fund market will have to adjust," says Hans Hufschmid, chief executive of GlobeOp Financial Services in London, which provides pricing services to some 600 hedge funds with total assets of about $65 billion.

Hufschmid, a former Long Term Capital Management principal, started GlobeOp in 2000 to help fund managers and their investors independently verify prices for the securities in their funds and gauge the risk they are taking on with their trades. Its services help alert investors of potential problems before hedge funds become insolvent. He recently spoke with BusinessWeek Banking & Finance Editor Mara Der Hovanesian. Edited excerpts of their conversation follow:

It seems remarkable that sophisticated institutional investors, not just average investors, get duped in this way.

Unfortunately, if someone is absolutely set on defrauding their investors, it's going to be hard to catch. Institutional investors invested in Enron, smart investors bought WorldCom. In general, thousands of hedge funds are invested in without any problems. Hedge funds all fully understand that it's important that investors maintain confidence in the industry, so most tend to have good rules in place.

What are some of the early signs of trouble?

There's no one set of rules, but there are warning signals. Most of the reputable funds have independent auditors and outside administrators that produce performance information for their investors. Strong independent review reduces the risk of fraud. Someone who committed fraud wouldn't go to the trouble of getting an independent third party to verify positions and prices.

The mechanism for pricing is generally stipulated in the private-placement memorandum that investors get when they initially invest. That document outlines the methodology for how portfolios will be priced. The majority of the hedge funds provide valuations once a month, but some do it more frequently. So the hedge-fund manager should not veer from the pricing methodology he or she stipulated.

If the fund has a relationship with a Wall Street firm to execute the trades, then at least there's an extra set of eyes looking at the trades and checking on the activities of the fund. A few hedge funds have their own broker-dealers, for example, and that means they could execute their own trades. That could pose issues.

So you don't want the hedge-fund manager pricing the securities themselves?

A lot of hedge funds have the ability to price the portfolio themselves. But ultimately, the investor wants to make sure that the pricing is independently verified and that they get external pricing from third parties [a list of alternative prices from Wall Street] and are provided those prices as backup to justify the value on the books.

If the manager is trading exchange-listed products, pricing is generally not an issue. But if the hedge fund is trading a lot of derivatives or esoteric mortgages or certain convertible bonds that trade infrequently, it may be more difficult to figure out what the price is, and the manager shouldn't be relied on as the single source.

Few, if any, investors can calculate that information themselves. Investors need to be able to rely on the auditors, the fund administrators, and the hedge fund itself to make sure the securities are properly priced.

What if a manager changes his investment strategy?

Before you give money to the hedge fund, you have to understand the risk it's going to take. The investor has to make sure that the manager takes no more risk than is outlined in the prospectus. Also, if the fund prospectus says it pursues a long-short equity strategy only, then the investor should make sure the manager isn't drifting into fixed-income or foreign-exchange investments by monitoring the types of investments on a monthly basis.

How about the pension consultants and fund-of-fund managers? How come they don't always catch problems despite the added fees?

That's not an unreasonable question. You have to be sure of what the fund-of-fund manager is selling you. Is it the ability to pick a good manager with sound infrastructure? Is it the ability to deliver performance? Are they hired to do background checks? Are they having managers fill out multipage questionnaires about how they generate returns and the types of trades they do? Do they visit them on a regular basis?

Investors should monitor their fund-of-fund managers just like the fund-of-fund managers need to monitor the hedge-fund managers.